NN IP: Strongest earnings season since 2010

The equity market currently gives confusing signals, with investors being torn apart between strong earnings reports, higher interest rates, bottoming macro surprises, and political developments (certainly positive on the Korean Peninsula but more uncertain as far as trade policy is concerned).

On the one hand, the US results season is developing very well. Currently two thirds of the S&P500 universe has reported results for the first quarter and around 80% of companies did better than expected. The average earnings surprise is 7% and the average sales surprise is 1%. Also the absolute growth numbers are good. Earnings growth amounts to 24% and sales growth is close to 10%. This makes it the strongest quarterly earnings season since 2010. Only two sectors reported single-digit earnings growth: consumer goods (+3.9%) and utilities (+1.5%). As expected, the highest growth is reported in the energy sector (+79%, driven by the big jump in the oil price), the basic materials sector (+35%) and the technology sector (+31%). It is also noteworthy that growth is not driven by tax-reform only (the average tax rate thus far has fallen by 5% from 25% to 20%) but even more by a further improvement in operating margins. Finally, earnings guidance remains solid with more than twice as much companies guiding consensus higher than lower, which is the best ratio since 2010.

On the other hand, the market response to these strong set of results has been lukewarm. Investors apparently are focussed on signals that a cyclical top in earnings is near, a reflection of their nervousness. Companies hinting at the top of the earnings cycle, rising raw materials costs or higher labour costs were punished even if the results beat expectations. The pick-up in capex is also a factor to watch. Generally speaking, companies launching a big capex program tend to underperform as investors fear a negative impact on cash flow available for dividends. However, the rise in capex is to a large extent attributable to only a handful of (tech) companies.

Anyhow, the recent stabilisation in the global earnings momentum is encouraging and could lay the foundation for better markets. For the US, the full-year earnings growth estimate has risen to 22% (+1.3% in 2 weeks).

Sector leadership change reflects nervousness

Another observation is the change in market leadership. This is a recent phenomenon. Since the start of the earnings season, both financials and the technology sector have underperformed the broader market, thereby ignoring their strong results.

The best performing sectors were defensives like utilities, telecom and real estate. The performance of these sectors, especially utilities and real estate, is counter-intuitive in the light of the increase in bond yields we have witnessed over the past few weeks (see Figure 1). It looks as if investors are also already looking for the top in the interest rate cycle. This seems at odds with the expectation of the Fed and most market watchers, including ourselves, of another six rate hikes by the Fed between now and the end of 2019.

A possible explanation lies in the positioning data for these sectors. Technology and financials are the two most overweight sectors in portfolios whereas utilities, telecom and real estate are underrepresented. This squaring of active positions looks consistent with the macro uncertainty investors are facing. We also made a similar move over the past months, by cutting our overweights in technology and financials and by upgrading consumer staples.

There may be an additional factor at work: relative valuation. Figure 2 illustrates the relative price-to-book of cyclical versus defensive sectors. This ratio is currently at the highest level in over 20 years, a period that includes the internet bubble.

Going forward, our focus will be on the trend in the macro data. After a period of negative surprises we now see a tentative bounce in the data, in both developed and emerging economies. Next to this, earnings releases and monetary policy are on our radar screen.